In another guest blog entry, Steven Kopits of Princeton Energy Advisors follows up on his previous post, examining whether the IOCs could really be headed to bankruptcy, as economist Philip Verleger suggests in a recent report. Steve can be reached at firstname.lastname@example.org and his blog can be found at www.prienga.com/blog
In my last Barrel post, I threw down the gauntlet to those casually predicting a collapse in oil prices, as such a collapse would effectively kill the oil business at the major oil companies. We will know, I wrote, that such forecasters are serious when they declare the international oil companies (IOCs) “to be the walking dead.”
No less than Phil Verleger, noted macro oil analyst, promptly took up the challenge. In his weekly note (April 21st), Phil notes that “long run fundamentals may indicate bankruptcy for large oil companies.”
“In the long run…companies betting on much higher [oil] prices will likely have a very unpleasant surprise: potential bankruptcy…[T]echnologies offered by firms such as SAP may soon consign high-cost projects to oblivion. The IOCs do not know it but they are manufacturing the equivalent of steam engines in an era when diesel locomotives are becoming the norm.”
How seriously should we take such an assertion? Are the IOCs really facing potential bankruptcy, or is the threat over-stated?
It is certainly true that IOCs need high oil prices to prosper, with Goldman Sachs suggesting free cash flow breakevens at $120/b or even higher for the major oil companies. Exxon and Chevron are budgeting with $109 and $110/b, respectively, for 2017, so we can certainly say that they are banking on high, if not higher, oil prices in the future.
At the same time, the IOCs are not manufacturing “steam engines.” They are producing one of the most desired, highest priced commodities in the world: crude oil. This is the state-of-the-art transportation fuel today, just as it has been, and the same commodity that nimbler independents are delivering.
The issue is not the product, therefore, but the business model. Verleger tangentially points this out, noting that IOC executives are incentivized to pursue larger projects. But it is not merely a question of incentives, but of fundamental comparative advantage.
When the petro economies like Saudi Arabia and others nationalized their oil companies back in the 1970s, the IOCs were essentially forced to find a niche in which they could out-compete the independents. They found their space in large scale, complex and capital intensive projects like deepwater, Arctic and LNG projects. These can require $20-50 billion of investments, a decade or more to find and develop, and the ability to manage and safely implement demanding drilling programs and integrate high spec subsea hardware and floating production systems. Very few independents can compete in this space, and the IOCs to this day dominate this category.
Blog post continues below…
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Nevertheless, this strategy has an Achilles heel: it depends on a large volume of readily accessible, undiscovered “elephant” fields—those greater than 400 million barrels of oil reserves. These are increasingly hard to find. For example, in 2013, there were arguably only five: Lontra (Angola, Colbalt Energy); Nene Marine (Congo, Eni); Maximino (Gulf of Mexico, Pemex); Coronado (Gulf of Mexico, Chevron); and Bay du Nord (Canada, Statoil). All were offshore, four in ultradeep water.
None of these reached 1 billion boe of reserves, and at the bottom of the list were scraping the 400 million boe limit below which project economics become problematic. Given the numbers of deepwater drilling units looking for oil in 2013, this was an exceptionally weak result on the oil side (although better on the gas side).
Of course, one year does not a project portfolio make, but it illustrates the challenges facing the IOCs. Perhaps three, maybe four, of the 2013 finds will become producers — not a great number to support all the IOCs. In a world in which large prospects are increasingly uncommon and increasingly expensive to produce, the IOC business model is under pressure — and Verleger is right on that point.
But will innovation undermine the IOCs? Verleger is surely correct that independents have out-produced all expectations. US onshore production was 1 million b/d more in Q1 2014 than a year ago, virtually all of that attributable to simply fantastic shale oil production growth. To this we could add 250,000 b/d of increased Canadian production, and the case for innovation looks strong on the face of it.
And yet, where has this impressive supply surge led prices? WTI is, in fact, $4/b higher than Q1 a year ago and $5 /b more than at the beginning of the shale revolution in Q1 2011. Brent is down in the last year, but only by $4/b. US shale oil production growth is actually associated with increasing US oil prices. To date, therefore, shale oil has not made a significant dent in oil prices.
Will prices fall in the future? From the supply perspective, this is questionable. If we believe Verleger’s assertion that the IOCs are doomed, then their production will surely fall. And it is. The majors’ oil production fell by 1.4 MMb/d in 2013, though a large chunk of this was a BP divestment and therefore not a loss to the oil system as a whole.
Still, if we accept Verleger’s thesis, a continuing decline of 0.8-1.0 MMb/d / year from the IOCs would certainly seem feasible.
Who will replace this? The Bakken and Eagle Ford are both at inflection points. It seems unlikely they can pick up the pace; and indeed, any number of analyses predict the pace of growth to moderate from 2016 or so. If US shale oil production is to be limited to the Bakken, Eagle Ford and recent production trends in the Permian, then today’s growth rates look unsustainable. This matters because US shales have been the growth engine not only of US supply, but also of global supply. Without US shales, global crude oil production would be lower today than it was in 2005.
Could innovation save us? It might, but it has not prevented IOC capex per barrel from rising at 11% per year — after adjusting for technological innovation. And it has not materially budged oil prices downward. Thus, if 2017 greets us with fading shale production growth and collapsing IOCs, then innovation has to produce a lot of barrels, as much 1-2 MMb/d / year, that is, up to twice recent shale production growth rates. Can innovation provide such a break-through? It could, but it certainly has not since 2005. As good an innovation as shale oil is, technology improvements to date have simply not been enough to move the needle.
So do the IOCs face bankruptcy? Probably not. They are increasingly migrating to natural gas, which is not facing the same challenges as oil. At least some of their revenues are sheltered. And oil prices, absent some fundamental shift in demand, will only collapse if the pace of innovation substantially surpasses the results of the last decade. For the moment, bankruptcy is not in prospect.
But Verleger’s central insight is right: the IOC oil business model is running out of room and the pressure on these firms will be unrelenting. And we are just at the beginning of adjustment period.